Issues Involving Surety for Public Transportation Projects (2012)

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35 learning that the courts will interpret “reasonable promptness” under the specific factual circumstances of the project.115 Once a claim has been made upon the bond, sureties have an independent obligation to inves- tigate the claim,116 and a reasonable time to conduct that investigation is part of the price to be paid for that security. Once the decision on how to proceed is made, additional time will be consumed in implementing the decision and remobilizing the project. For this reason, owners should always factor a period of unrecoverable delay into their evaluation of whether to default and terminate a contractor. G. Conclusion Large contractor defaults are rare, and generally only large contractors bid on and obtain contracts for large transit projects.117 Thus, owners should infre- quently be faced with the issues of terminating for de- fault the contractor on a large transit project and seek- ing performance by the surety. While, rare, however, defaults do occur, and owners should have contingency plans in place to mitigate the impact of default. As dis- cussed elsewhere in this digest, the type of failure that is most likely to confront a transit owner is the type of total corporate collapse that an owner may not be able to detect from the conduct and administration of its own project.118 First and foremost when confronted with conditions amounting to a default, owners should be aware of the requirements of the applicable contract and bond on their rights. Second, owners should be careful in ensuring their own compliance with their contractual obligations. Third, owners should plan for the cost and time impact on the project in the event a default occurs. As explained above, while there are sig- nificant costs that will be borne by the contractor's surety, there are unrecoverable costs and time impacts on the project that the owner will bear. Contingency funding and planning are, therefore, essential compo- nents to any transit agency’s development of a project. VI. COMMERCIAL ISSUES AFFECTING THE SURETY RELATIONSHIP ON LARGE, COMPLEX PROJECTS As noted in Section II, more and more public infra- structure projects are being delivered through DB and other alternative project-delivery systems. Coupled 115 Id. at 83 (citing Seaboard Sur. Co. v. Town of Greenfield, 266 F. Supp. 2d 189 (D. Mass 2003) (promptness inquiries must focus on whether the surety’s actions were reasonable under the circumstances of the underlying default, the status and complexity of the project, and the availability of informa- tion)). 116 Dodge v. Fid. & Deposit Co. of Md., 161 Ariz. 344, 778 P.2d 1240 (1989) (commonly recognized that once a claim arises, the surety has a duty to independently investigate the claim). 117 See Rice & Heimbach, supra note 109, at n.1. 118 See ch. X. with the relatively recent increase in the number of public-sector large-dollar contracts, this has led to a challenging surety environment. Contracts on alterna- tive delivery systems generally shift greater risk to the private sector than do contracts on DBB projects. Since sureties ultimately take on these risks if there is a de- fault, they pay attention to the contracts—particularly on large and complex projects. To facilitate a better understanding of the myriad of commercial and liability issues affecting the surety in- dustry’s position on large projects, this section explores some basic contract and bond form issues, including 1) the contractual clauses to which sureties give particular attention, 2) the 2010 updates to AIA’s bond forms, and 3) nonstandard bond forms and obligations that will be of concern to sureties. In addition to evaluating contract and bond terms, this section discusses the implications of bonding subcontractors and the underwriting con- cerns presented by the influx of multinational contrac- tors to the U.S. large-project market. This section concludes with a review of how surety capacity has influenced the packaging of certain large- dollar projects and resulted in reductions to 100 percent performance bond requirements. This topic is raised in several other sections, including Sections III, VIII, and the Section IX case studies. A. Significant Contract Provisions One factor influencing the surety underwriting proc- ess is the risk-shifting provisions of the bonded con- tract. Contractors are now working more closely with sureties in the initial phases of a project (e.g., after pub- lication of the RFP and during contract negotiation), which is precisely the time sureties prefer to be brought in to review and negotiate key contract terms. As a sig- nal of the sureties’ heightened contractual involvement and awareness of contractual risk, Zurich North Amer- ica Surety recently developed a risk management de- partment based upon the company’s perception that the majority of its losses in recent years could have been mitigated by more favorable contractual clauses.119 Zu- rich’s then-president, William E. Cheatam, stated, “Now…we keep track of risk-shifting clauses. And we are building an underwriting knowledge center.”120 As part of its overall project risk assessment, the surety will focus on the following contractual provi- sions, annotated from the surety’s perspective: • Payment Provisions—Are there any unique fund- ing concerns that will raise issues for the contractor or JV’s cash flow? • Retention—Is there a corresponding decrease in the retainage withheld as the work-in-place increases? Is the percentage of retention equitable? 119 See Richard Korman, Underwriters Reshaping Construc- tion Industry One Surety Bond at a Time, Northwest Construc- tion (Apr. 2007), http://northwest.construction.com/ features/archive/0704_feature2_story.pdf. 120 See id. at 61.

36 • Completion Date—Is the proposed duration of the contract feasible, reasonable? • Liquidated damages—Is the proposed stipulated sum commensurate with the actual or projected dam- ages the owner may incur? Is there a cap on liquidated damages or some other provision that would act as a stop to prevent extended delays? If there is no liqui- dated damages provision, the surety might want its contractor to negotiate for one to mitigate against lar- ger undefined or unknown delay-related damages, and as an incentive for the bonded contractor to complete the work on time. • Limitation of Liability—Does the bonded contract contain an enforceable clause that clearly defines the maximum exposure that the contractor will be respon- sible for in the event of continuing defaults? • Hazardous Materials—Does the hazardous mate- rials provision require the contractor to assume cleanup obligations and be considered a generator of pollution under federal hazards waste law? If so, is the clause fair and reasonable so that the owner indemnifies for hazardous materials that are unknown? Federal laws concerning cleanup of hazardous sites make this a ma- jor cost risk for all parties in dealing with spills, leaks, or other costs of hazardous materials. • Differing Site Conditions—If the bonded contractor encounters unforeseen soil conditions, does the owner assume the risk or does the contract make it difficult for the contractor to recover on such a claim? Typically, the means for reducing the risk of unforeseen conditions is through test borings. When an owner generates data and guarantees the accuracy of the interpretations, contractors encountering changed conditions will seek to have the owner liable for the representations. Like- wise, if the owner provides little to no information on soil conditions, the risk shifts to the contractor to bear the costs of dealing with whatever conditions are found. This is likely to be reflected in the price of the bids, however. • Specifications for Construction—Are the specifica- tions performance or design specifications? How does the bonded contractor view the level of detail and qual- ity of the design documents—regardless of whether the project is delivered through DBB or DB? • Insurance—Do the requisite insurance provisions address the design component of a DB contract? In other words, is the surety adequately protected from design problems on a DB contract with the requisite design professional liability insurance? Does the insur- ance provision adequately insure the contractor teams involved in the project? • Warranties/Performance Guarantees—What is the length and duration of the warranty period? Is the war- ranty a standard 1 to 3 years (i.e., workmanship and materials), or does the warranty clause impose per- formance guarantees (i.e., 15 to 20 years).121 If it is a 121 See William Neuman, New Bus Fuel Contract Softens Warranty that Saved Agency Money, N.Y. TIMES, Sept. 27, 2008, available at http://www.nytimes.com/2008/09/27/ performance-type warranty, how is performance success measured and quantified? Who are the parties contrac- tually responsible for the performance guarantees if the contractor is a DB JV team? Is the performance guaran- tee clause specific to the contractor or designer, assum- ing it is a DB project delivery method? • Substantial Completion—Are the terms for sub- stantial completion onerous or industry standard? Are there third-party impediments or required items over which the contractor has no control that would make achieving substantial completion difficult? • Contract Close-Out—Does the close-out process appear to be streamlined and achievable? Are there provisions in the close-out process that extend or go beyond what is typical? • Default Provisions—Should a default be occasioned on the project, is the owner required to give notice in advance and an opportunity to cure? Does the default provision require notice to the surety? Does the provi- sion entitle the owner to default a portion of the work? • Hold-Harmless and Indemnification Provisions— How broad are the obligations to which the contractor is agreeing? Do the hold-harmless and indemnity provi- sions include the duty to defend the owner (i.e., hire legal counsel and pay additional attorney’s fees)? Do the hold-harmless and indemnity provisions require the contractor to indemnify the owner for attorney’s fees, even if the contractor is suing the owner for breach of contract? • Bonding Provisions—Assuming the bond forms are industry standard forms, such as AIA, EJCDC, or Con- sensusDOCS, the surety will not be concerned. Bonds that are not standard industry forms will take longer for the surety to review to determine the level of risk with each bond provision, such as notice, default, dura- tion, completion effort, and penal sum. FTA’s Best Practices Procurement Manual provides specific guidance on each of these contractual clauses from the transit owner’s perspective.122 The above clauses become part of the underwriting process, and therefore are part of the commercial deal negotiated between the contractor and owner. There are also an abundance of unique contract clauses that public obli- gees have sought to include in contracts and that sure- ties typically resist or refuse. One example of these con- nyregion/27fuel.html, as a recent example of how warranty language negatively impacted a transit owner’s bus fuel con- tracts for New York City. In 2006, New York City Transit found a black “tacky” substance collecting in the fuel pump and diesel storage tanks at its bus depots. It used the broad war- ranty clause in its contract to require the fuel supplier, Spra- gue Energy, to pay $1.8 million for the cleaning. However, when New York City Transit re-bid the contract in 2008, it received no offers to bid. The agency was left “scrambling” to write a new contract with Sprague so that it would not run out of fuel. The fuel supplier not only increased its price to add $26 million annually to the contract, it refused to sign the contract unless the warranty provision was taken out. 122 FED. TRANSIT ADMIN., supra note 71 §§ 8.2, 9.2, 10.1.

37 tractual provisions includes those that increase the pe- nal sum of the bond for change orders, without notice to the surety. A common provision is as follows: Any increase in the Contract amount shall automatically result in a corresponding increase in the Bond's penal amount without notice to or consent from Surety, such notice and consent being hereby waived. Decreases in the Contract amount shall not, however, reduce the Bond's penal amount unless specifically provided in said Change Order. In the past, the surety industry has negotiated this clause to include an increase in the penal sum of the bond for change-order work but to limit that increase to a percentage increase without surety consent:123 The Penal Sum of this Bond shall automatically increase as the Contract Amount increases; provided, however, the initial Penal Sum shall not increase more than ___% ab- sent the Surety's written consent. Surety's refusal to con- sent to such an increase in the Penal Sum shall not be a breach of this Bond. Other contract clauses that put sureties on “high alert” include those that purport to have the surety waive notice of all changes, extensions of time, supple- mentation of work, or cancellation of the contract. Ex- amples include: The Principal shall ensure that the Surety is familiar with all of the terms and conditions of the Contract Documents, and shall obtain the Surety's written ac- knowledgment that it waives the right of special notifica- tion of any changes or modifications of the Contract, or of extensions of time, or of decreased or increased work, or of cancellation of the Contract, or of any other act or acts by the Obligee or any of its authorized agents. While it is common to have a contractual or bond provi- sion stating that the surety waives notice of changes, other clauses, like the one above, that purport to waive notice of “cancellation of the Contract…or of any other act…by the Obligee…” arguably could be interpreted to mean that the surety waives all of its defenses against the owner for nonpayment.124 B. The 2010 Modifications to AIA’s Bond Forms The AIA bond forms are commonly used throughout the U.S. construction industry, even on civil works pro- jects. It is thus worthwhile to note the changes made to the form when AIA released major revisions in 2010. Some of these changes are also discussed in Section V. Developed in 1970, AIA’s bid bond form had not been changed since its debut. The 2010 revision, AIA A310- 2010, is similar to the original form, with the biggest change being that the surety has to be notified if an extension of more than 60 days is granted to accept the bid. 123 Marilyn Klinger, International Risk Management Insti- tute, Inc., Killer Bond Forms and Contract Provisions (Aug. 2007), www.irmi.com/expert/articles/2007/klinger08.aspx?cmd=print (last accessed May 5, 2011). 124 See id. The 2010 updates to AIA’s A312 performance bond conditioned the surety’s performance bond obligations on the owner not being in “default.” Arguably, this bol- sters the surety’s ability to refuse obligee claims on the bond in the event the contractor defaults. It is one of the key reasons owners sometimes elect to use LOCs as performance guarantees. As discussed more fully in Section IV, there is no true ability to argue owner de- fault with LOCs, whereas performance bonds provide several proverbial “outs” for the surety.125 A multitude of other major changes to AIA’s 2010 performance bond form protect and enhance the obli- gee’s interests, which include 1) allowing the owner the discretion as to whether to request a conference with the surety prior to declaring a contractor default;126 2) eliminating the 20-day period the owner had to wait after providing notice before actually terminating the construction contract;127 3) providing that the owner’s failure to comply with the notice provisions is not a condition precedent to the surety’s liability on the bond128 (as had been argued and ruled in favor of the sureties for years); and 4) expanding the surety’s per- formance obligations beyond the penal sum if its elects to undertake to perform and complete the construction contract.129 Regarding the AIA-A312 payment bond form, new language exists to clarify the surety’s responsibility to defend, indemnify, and hold the owner harmless against a subcontractor claim.130 In addition, there is no longer a 30-day waiting period for a claimant to send notice to the surety after sending notice of nonpayment to the contractor. The most significant change to the bond form, however, is language that states that the surety’s failure to act under the bond is not a waiver of defenses. Finally, the new payment bond form incorpo- rates a new definition of “claim,” which is designed to provide the surety with the information necessary to begin evaluating the claim’s merits. C. Nonstandard Bond Forms An owner’s use of nonstandard bond forms generally creates anxiety for the surety, as these forms inevitably use language that is confusing, contradictory, or con- trary to the surety’s interests. Set forth below are some specific bond provisions that owners put forth as a “belt and suspenders” measure to reinforce the surety’s li- ability for the contractor’s performance. 125 See David J. Barru, How to Guarantee Contractor Per- formance on International Construction Projects: Comparing Surety Bonds with Bank Guarantees and Standby Letters of Credit, 37 GEO. WASH. INT’L L. REV. 51 (2005). 126 See AIA Bond Form Commentary and Comparison, AIA Documents A310-2010 and A312-2010, at 2, http://www.aia.org/aiaucmp/groups/aia/documents/pdf/aiab083 075.pdf. 127 Id. 128 Id. 129 Id. 130 Id.

38 1. Surety Liability for Extended Warranties As noted in Section VIII, transit agencies and state DOTs have recently sought to shift responsibility for quality control and maintenance to contractors through contractual warranty periods with extended durations, some lasting 15 to 20 years.131 This is not a surprising trend, given the financial pressures faced by state DOTs and transit agencies. States facing budget deficits have reduced the number of public employees on their payrolls, thereby impacting their ability to perform in- spections and maintenance. As a result, state transit agencies and DOTs are now using long-term warranties with increasing frequency.132 Indeed, both FTA and FHWA are encouraging contracting for long-term war- ranties as an innovative contracting technique: [FTA] grantees are encouraged to exercise sound business decisions in structuring broader and more comprehensive warranties than that offered as a matter of trade practice or as an industry standard (i.e., an “extended warranty”) where such warranties are advantageous and cost effec- tive. Such business decisions must be based upon market research and price/cost analysis.133 Though longer warranty periods are embraced on the owner side, contractors and the surety industry are generally opposed to this major risk-shifting trend.134 The SFAA, the preeminent lobbying arm for the surety industry, gives the following policy statement with re- spect to why it opposes extended warranties: When a surety writes a bond for a contractor, it is making a judgment about the contractor’s financial and opera- tional viability. As the duration of the bonded obligation becomes longer, and the surety must assess the contrac- tor’s operation for periods of time well into the future, the certainty of the judgment may be lessened. This is the case with a warranty bond that has a long-term duration. In addition to the uncertainty involved in underwriting a contractor far into the future, the method of payment for the work under the warranty also increases the risk to the surety. As the contractor progresses during the con- struction period of the project, the contractor is paid only for work put out in place. If the contractor defaults and the project is incomplete, the balance of contract funds should be available for the surety to complete the project. However, under most contracts, the contractor is paid fully upon final completion, leaving no contract balances to fund any warranty work. Therefore, if a surety must 131 Surety & Fidelity Association of America Statement Con- cerning Bonding Long-Term Warranties, The Surety & Fidelity Association of America, http://www.surety.org/GovRel /LongTermWarrantyStatement.pdf. 132 Qingbin Cui, Philip Johnson & Elizabeth Sees, Long- Term Warranties on Highway Projects, Department of Civil, Construction & Environmental Engineering, The University Transportation Center for Alabama (Sept. 2008), available at http://utca.eng.ua.edu/research/projects/?id=6109. 133 FED. TRANSIT ADMIN., supra note 71 § 6.3.5 (revision 2005); https://www.fhwa.dot.gov/pavement/warranty/index.cfm (last accessed Apr. 29, 2011). 134 Neuman, supra note 121. step in to complete the warranty work, it does not have any contract funds available to mitigate its loss. The SFAA argues that to compensate for the in- creased risk due to the diminished certainty of under- writing and the method of payment, sureties typically raise their underwriting standards and provide long- term bonds only to the largest and most financially sound contractors. As a result, they say, many smaller contractors who are fully qualified to do the work would be precluded from bidding on these projects. If sureties raise their underwriting thresholds high enough to ad- dress the risks and uncertainty of an obligation lasting 10, 15, or 20 years, very few contractors compete for the project, which may cause an increase of bid prices and construction costs. Finally, they argue that long-term warranties also increase the costs of the surety bond itself. Because sureties are attentive to the duration of their obligations under a contract or bond, they will generally object to a provision such as, “If Principal shall well and truly perform all the undertakings, cove- nants, terms, conditions, and agreements of the Con- tract within the time provided therein and any exten- sion thereof that the Obligee may grant, and during the life of any guarantee or warranty required under said Contract….” As noted in the SFAA policy statement, this provision, whether in the bond itself or the under- lying contract, would create an exposure that would be difficult to assess, particularly if there is any meaning- ful chance that the contractor would no longer be a cli- ent of the surety. 2. Surety Liability for Punch List and Latent Defects Another bond provision that some owners try to in- sert into nonstandard forms addresses punch list and latent defects: The condition of this obligation is such that, if Contractor shall fully, promptly, and faithfully perform the contract and all obligations thereunder, including punch list, then this obligation shall be null and void; otherwise, it shall remain in full force and effect. The Bond shall remain in full force and effect and cover latent defects after the cer- tificate of substantial completion and after Obligee accep- tance of the construction. The above bond provision defines the surety’s liabil- ity as extending through a period where latent defects might be uncovered, however far into the future that may be. Similar to the extended warranty issue, this poses great concern to the surety, as it could be respon- sible for decades, depending on the statutes of repose in a given state. Most performance bonds will have some cut-off date (i.e., 1 or 2 years from substantial comple- tion) to avoid this potential exposure. 3. Attorney’s Fees in Excess of the Penal Sum A surety’s liability is generally limited to the penal sum of the bond, including attorney’s fees incurred in enforcing the bond. A term sureties sometimes find in nonstandard bond forms that tries to expand the penal sum is as follows: “Principal and Surety agree that if

39 Obligee is required to engage the services of an attorney in connection with enforcement of this Bond, each shall pay Obligee’s costs and reasonable attorney’s fees in- curred, with or without suit, in addition to the above penal sum.” The above provision is premised on the theory that the penal sum corresponds with the con- tract default and the costs to complete, but that an owner’s attorney’s fees spent in trying to recover against the bond should be recoverable over the penal sum. “If the attorney’s fees that an obligee must expend to recover against a surety can eat away at the penal sum, there is less money available for the obligee to complete the project or reimburse itself for the costs of completion.”135 Needless to say, sureties object to this clause, as they view their obligations as being limited to the penal sum for any theory or type of claim arising out of the default. D. Use of Bonds on Concession Contracts Most state agencies like to ensure that all down- stream suppliers and subcontractors on a project are paid. They do so by, among other things, requiring the prime contractor to obtain a payment bond that benefits those parties. Needless to say, this is a requirement for which subcontractors heavily lobby, as they do not have the right to file a mechanic’s lien on the project by vir- tue of sovereign immunity—public property cannot be liened. While payment bonds are standard protocol on most public-sector construction projects (at least in those states where it is required by statute), there is a practi- cal problem on PPP projects (i.e., DBFOM projects) where the owner contracts with a concessionaire. Be- cause the owner does not have a direct contract with the DB team, policy questions arise as to whether any type of surety bonds will be required from the DB team. In these cases, agencies have had to consider whether requiring a performance or payment bond from the con- cessionaire itself gives the agency a real benefit in the event of a default—particularly when the project fi- nancing is being provided almost exclusively by the concessionaire. At this point in time, most highway PPP projects us- ing concession arrangements have not required either the concessionaire or its design-builder to provide per- formance or payment bonds for the benefit of the agency. This is a dynamic situation, as there are public policy concerns as to whether the interests of subcon- tractors and suppliers are being appropriately pro- tected. Some state DOTs have considered mitigating this problem by mandating the use of escrow accounts or limited payment bonds. E. Multinational Teams/International Contractors Another unique issue affecting sureties on transit projects is the prevalence of national contractors team- ing with non-U.S. (foreign) contractors to form joint ventures for bidding on projects. The difficulty for sure- 135 See id. ties in agreeing to bond foreign contractors is essen- tially an underwriting concern. Underwriting decisions involve a complex risk assessment of the credit, capac- ity, and character of the bonded contractors—and that assessment is altered and poses challenges for sureties in evaluating contractors on the international stage. At its core, the term “underwriting” means to as- sume another’s liability or risk, but it is also used to describe the process of determining whether, and under what terms, one will agree to assume that liability or risk. In the construction surety bond context, the un- derwriting process involves a careful examination of the reliability of the contractor, both in terms of perform- ance ability and financial stability. A surety’s agree- ment to bond a contractor not only reflects the surety’s pledge to stand liable for the contractor’s obligation, but also acts as a stamp of approval that signifies the con- tractor is capable of properly and timely completing the construction project for which it has obtained the bond. The underwriter’s duty is to be as certain as possible that the contractor will be able to properly and timely perform the bonded work and thereby avoid any claim on the bond. Thus, obtaining a surety bond acts as a sort of stamp of approval, prequalifying the contractor as capable of performing the construction project. As discussed at length in Section III, even if the con- tractor defaults on the bonded contract and the surety is forced to pay a claim, the surety does not expect to suffer any net loss. Underlying this theory is the fact that the surety has a right of indemnity from the con- tractor for any claims the surety pays on the bond. Realistically, however, the contractor often lacks the resources to fully indemnify the surety in the event of a major claim. Obligated to pay the claim but unable to fully recover the costs from the contractor, the surety will then suffer a loss. The ratio of a surety’s losses to the amount of bond premiums earned is called the “loss ratio.” Instead of charging higher premiums to provide a financial cushion for possible claims, sureties rely on their underwriting practices to avoid that risk. Some of the risk factors that surety underwriters typically ex- amine are: • Contractor’s financial books and records (credit, capacity, and character). • Contractor’s prior experience in building that type of project. • Dollar value of the project relative to the contrac- tor’s previous largest job. • Construction financing. • Geographic location of the project/site conditions. • Availability of labor. • Availability of subcontractors. • Availability of materials. • Contractual provisions. • Bid evaluation.136 136 Rolf Neuschaefer, Project Risk Assessment, Insurance Risk Management Institute (IRMI) (Oct. 2002) (www.irmi.com /expert/articles/2002/neuschaefer10.aspx?cmd=print) (last accessed Apr. 20, 2011).

40 Regarding the evaluation of the potential indemnitor’s assets, sureties typically prefer “unencumbered tangible assets that can quickly and easily be liquidated into cash.”137 Examples include cash, certificates of deposit, irrevocable LOCs from acceptable financial institutions, U.S. government securities, stocks and bonds actively traded, or real property owned in fee simple. Con- versely, not only is it more difficult to accurately assess a foreign contractor’s books and records, but the assets a foreign contractor has to offer in case of a potential loss would be difficult for the surety to seize, recover, or liquidate. This is certainly not to say that U.S. sureties do not bond teams where a foreign contractor is one of the par- ticipants. From select interviews with the major na- tional sureties who underwrite and bond the majority of transit projects, underwriters advise only that the addi- tion of a foreign contractor member makes the process more cumbersome; there are more issues to deal with in assessing capacity, character, and capability; and the underwriting may take longer as a result. Moreover, the likelihood increases that a co-surety arrangement will occur to spread the perceived risks to the surety. F. Bonding the Big Dollar Project The challenges of bonding the large-dollar project have been discussed in several areas of this digest. As noted in Section VIII, senior members of the surety in- dustry have stated that there is currently no limitation on the amount of a bond that can be provided for a sin- gle project. However, it is clear that in the not-too- distant past the surety market had an informal “cap” on how much of a penal sum any individual surety would provide for a single project, particularly on DB projects. While the amount of that “cap” was never di- rectly ascertainable, it appears to have been in a range of $250 to $350 million.138 The reality of this bonding “cap” is reflected in several periodicals that have been issued to address the use of DB, turnkey, and PPP con- tracting methods in the transportation sector.139 137 George Thomas, How Surety Bonds Work, Kilcullen, Wilson & Kilcullen (1996), www.attny.com/gciart2.html (last accessed Apr. 22, 2011). 138 These numbers are based on Mr. Loulakis’s direct ex- perience with several large projects in the 2005 to 2007 period, and have been confirmed by several senior industry surety and contractor individuals who preferred to provide information on a nonattributable basis. 139 While a “cap” of some sort could have been based on a variety of factors, it should be noted that in the early part of this decade, 12 reinsurers stopped underwriting surety lines altogether, leaving only 10 reinsurers in the market. Because sureties rely upon reinsurance to spread the risk associated with bonding large dollar projects, the market consolidation of the reinsurance industry raised concerns regarding surety capacity for larger projects. See Grant Thornton, LLP’s 2007 Surety Credit Survey for Construction Contractors: The Bond Producer’s Perspective, Grant Thornton LLP, Chicago, IL, http://www.grantthornton.com/staticfiles/GTCom/files/Industri One of the earliest pronouncements of bonding con- straints on large projects was made in FTA’s October 1997 publication, Lessons Learned: Turnkey Applica- tions in the Transit Industry.140 In relating the overall experiences for these first-in-breed DB projects, the report discussed surety issues as follows: Large Turnkey Projects. Often in large turnkey projects such as [the Honolulu Rapid Transit Project and Houston Fixed Guideway Project], the bonding requirements would have exceeded the ability of the surety industry to provide bonds. Big umbrella bonding or excessive bonding requirements can be restrictive of competition and often create a major barrier to contractors willing and able to participate in turnkey advances. Large conventional or turnkey contracts which are not parceled into small, more manageable segments can cause extreme problems (sic) and might also prevent participation by many prospective contractors, especially (sic) small and disadvantaged business. One approach to addressing this issue is to de- velop smaller, finite construction packages that can be accomplished incrementally through an addendum proc- ess, such as the process used by Los Angeles County MTA on its Union Station Gateway Project. Owners of large turnkey projects should be sensitive to this important is- sue, and consider carefully breaking up of very large con- tracts into smaller sizes. Such a scenario may result in a more manageable task, often providing simpler and clearer understanding as to the scope of the contract. This will make the project less risky, thus easier to bond and insure, which can in turn have an enormous impact on the ability and competitiveness of small and disadvan- taged firms.141 This sentiment was repeated in Chapter 8 of FTA’s Best Procurement Practices Manual, which states: Design-Build Projects. For design-build projects and large transit capital projects (those over $200M) it would be advisable to talk to prospective sureties before the solici- tation is issued to see if the Design-Build contractors will have problems securing bonds because of the size of the project. There are two problems to be aware of: (1) the lack of bonding capacity in the industry at the current time, and (2) the fact that surety practice has historically been based on the conventional Design-Bid-Build method, where design and construction are performed by separate companies and where sureties have detailed designs com- pleted for which they can assess the performance risks. On a Design-Build project, the lack of detailed designs desired by sureties to evaluate project risk may make it difficult to obtain performance bonds for the full value of the contract.142 es/ConstructionRealEstateAndHospitality/2007_surety_survey _new.pdf. 140 This publication reported on four transit projects that FTA selected to participate in its Turnkey Demonstration Pro- gram. The four programs were the Baltimore Light Rail Exten- sion, San Juan Tren Urbano Rail, El Segundo Del Norte (Green Line) Station, and BART Airport Extension. 141 FED. TRANSIT ADMIN., LESSONS LEARNED: TURNKEY APPLICATIONS IN THE TRANSIT INDUSTRY V-4, TRB abstract available at http://trid.trb.org/view.aspx?id=473658. 142 FED. TRANSIT ADMIN., supra note 71, § 8.

41 Likewise, a June 2009 report, Current Design-Build Practices for Transportation Projects, A Compilation of Practices by the Transportation Design-Build Users Group,143 discussed the surety issue on large projects as follows: For larger projects, agencies are often willing to accept reduced bond amounts, with the amount, based on the po- tential cost overruns resulting from a "worst case" sce- nario. * * * * * The decision to accept a reduced amount is based in part on the surety industry's reluctance to issue 100% bonds for mega-projects, and in part on the fact that only a handful of contractors have sufficient bonding capacity to provide such bonds. Requiring a 100% bond would therefore be likely to reduce the pool of interested contractors and could therefore have a significant impact on the contract price.144 Another report worth noting is the Report to Con- gress on the Costs, Benefits, and Efficiencies of Public- Private Partnerships for Fixed Guideway Capital Pro- jects (PPP Report to Congress), referenced extensively in Section II. Consistent with industry rumblings regard- ing a “cap” on surety bonds, this report reiterated and underscored FTA’s previous assessments, and cited the challenges of obtaining conventional bonding on PPP projects. Noting the then-current status of state bond- ing requirements, which largely required 100 percent performance and payment bonds, the report suggested that state and local transportation agencies should have greater flexibility with respect to the types of financial security needed for PPP projects. Ideally, [PPP statutes] would provide a simple exemption from those requirements and authorize the agency to de- velop its own approach to financial security requirements that can be flexibly applied to the needs of each PPP pro- ject on a case-by-case basis. In this way, the interests of the parties, the project and the public can all be weighed and advanced.145 Among the reasons cited in the PPP Report to Con- gress in making a recommendation for flexibility in surety bond requirements were the following: • Providing full surety bonds on very large projects limited competition and could exceed the bonding ca- pacity of many potential competitors. • Shortlisting processes on PPP projects consider fi- nancial and technical capabilities, which is different from traditional low-bid procurements. • A standard requirement for PPP programs is the obligation to provide parent company guarantees, and 143 The Transportation Design-Build Users Group consists of a number of transit agencies and DOTs around the country, and this report reflects a compilation of the design-build ex- periences of these members. 144 FED. TRANSIT ADMIN., supra note 71, § 14.2, at 64. 145 FED. TRANSIT ADMIN., REPORT TO CONGRESS ON THE COSTS, BENEFITS, AND EFFICIENCIES OF PUBLIC-PRIVATE PARTNERSHIPS FOR FIXED GUIDEWAY CAPITAL PROJECTS 30 (2007), http://www.fta.dot.gov/documents/Costs_Benefits_ Efficiencies_of_Public-Private_Partnerships.pdf. many proposers are consortia of companies, each of which provides such a guarantee. • The private partners in a PPP can be required to provide LOCs and other forms of security in the event of a default. • Most PPP projects involve a wide range of services other than construction, and it may be inappropriate to require these nonconstruction services to be bonded.146 It is evident that FTA has taken this particular surety issue seriously, as it has regularly consulted with the business community to reduce unnecessary bonding and has granted waiver requests by grantees of the 100 percent surety bond requirements. It started with the San Juan Tren Urbano project, one of FTA’s turnkey demonstration projects procured in the mid- 1990s. Tren Urbano procured a number of prime DB contracts, all of them in significant dollar values. San Juan sent FTA a request for a waiver of the 100 percent bonding requirement, based on the surety market stat- ing that it could only provide 50 percent bonds. FTA approved the request, after considering how the propos- als were obtained and evaluated, as well as a summary of the character, financial capacity, and technical ex- perience of the bidders.147 A number of projects discussed in this digest demon- strate FTA’s willingness to allow grantees to use less than 100 percent bonds. In discussions with senior per- sonnel from FTA, the authors learned that there are no written or formal policies as to how FTA makes the de- cision to allow reduced bond amounts. Likewise, FTA does not appear to have a formula for, or policy on, set- ting the reduced bond amount. The discussions indi- cated that FTA makes these decisions based on a vari- ety of factors, including 1) the ability of the surety market to provide performance bonds in the amount of the contract price; 2) the amount of self-perform work being performed by the prime contractor; 3) the pro- curement policies of the prime contractor and whether it requires subcontractor bonds; 4) the procurement process undertaken to contract with the prime contrac- tor; and 5) the financial creditworthiness and reputa- tion of the prime contractor, and its ability to stand behind the performance of the contract. While much of the “large-dollar project” discussion in this digest and in the industry has focused on reduced bonds, it should be noted that several owners have handled this situation by descoping large contracts into smaller packages. Strategic contract packaging is done not only on alternatively delivered projects, but also on conventional DBB projects. A prime example is how the New York City MTA handled its DBB process for three megaprojects procured during the mid-2000s: the Num- ber 7 Line Extension, East Side Access, and the Second Avenue Subway. The Number 7 Line Extension project, which was projected to have a total cost of approximately $2.2 bil- 146 Id. at 31. 147 FED. TRANSIT ADMIN., supra note 141, at V-11.